Theme 1: Timing the global recession
From an economic growth perspective, a soft and shallow global recession is our base case as of this writing, although we are carefully monitoring both upside and downside risks. On one hand, a more severe downturn could materialize if financial sector fragilities were to be exposed, including high levels of private sector leverage, falling real estate prices, and the risk of permanent capital erosion from write-downs in private investments. On the other hand, a stronger-than-expected or faster-than-projected rebound of China’s economy could provide a global economic stimulant, with increased Chinese demand for crude oil, copper, and other commodities benefitting exporters of such goods. While we believe the true impact of China’s economic reopening is more likely to be felt later in the year (given the recent COVID wave that swept across the country), the actual timeline will be worth tracking.
Meanwhile, global inflation appears to have moderated somewhat, with consumers in many countries now experiencing some relief from the inflationary pressures that had been building for the past year or so. Recent cyclical weakness, coupled with a milder-than-expected winter heating season in Europe thus far, have led to falling energy and food prices worldwide. Fixed income markets have recently started to price in interest-rate cuts in the second half of 2023, on the back of lower global growth forecasts. However, we believe economic conditions would need to deteriorate meaningfully for the major central banks to change course on monetary policy. In our judgment, a shallow, soft recession wouldn’t be sufficient to reduce inflation to central banks’ target levels. We therefore think pauses in their interest-rate hikes later this year look more plausible at this point than rate cuts.
Actionable takeaways for income investors:
- Keep portfolio duration (interest-rate exposure) relatively low.
- Increase allocations to high-quality, short-duration credit.
- Maintain allocations to defensive equities and real assets.